Govindarajan and Anthony (1986) conducted a survey in which over 500 US industrial companies answered a questionnaire on how they set prices. They found that 85% of companies surveyed used full cost pricing (Govindarajan and Anthony 1986: 31), and, in contrast to conventional marginalist theory, most businesses certainly do take account of fixed and allocated costs: therefore “sunk costs” are important in determining the administered price.

Govindarajan and Anthony also found that relatively few business managers could estimate the demand curve for their product: that is, an estimate of the quantity that would be demanded at a particular price (Govindarajan and Anthony 1986: 32).

Shim and Sudit (1995: 37) – the next study – conducted a survey in 1993 of US industrial companies, and found that 69.5% used full cost pricing.

Both surveys, then, suggest that from the 1980s to the 1990s full cost pricing accounted for roughly 70% to 85% of US industrial prices.

These findings have shocked neoclassical economists, who resort to special pleading to explain such price setting away as a kind of “irrational” behaviour by managers and firms (e.g., Al-Najjar, Baliga, and Besanko 2008).

6 comments:

I've seen a number of Austrians concede that prices are administered in the short term but in the long term they do adjust according to supply and demand. They claim in the long term, prices do adjust and clear markets. Any thoughts?

LK, I tried to find the source which I saw a couple of weeks ago but it was a response to your own material. It was on some libertarian forum but I can't remember which one. One of the points being made was that prices do adjust during a trade cycle but they also adjust when you have inflation or deflation. The common response was, sure everyone accepts that prices are sticky in the short-term but they do adjust in the long-term. They didn't seem to think administered prices were a problem for the free market.

The general price changes in the different phases of a trade cycle -- inflationary during booms and disinflationary during recessions -- are simply not the same thing as flexible adjustment towards market clearing price levels. These are two different things (and since 1945 it is rare for the recessions to even have deflation).

During recessions administered price firms simply cut production and employment, but their prices can actually move in either direction upwards or downwards. Even if they move downwards it more likely because of factor input price changes, not because they cut prices to clear all their markets.

In short, any postulated "long term" adjustment is not supported by the empirical evidence any more than short term adjustment is.

Any libertarians who think that administered prices are no problem for free market economics simply have their heads in the sand.

Doesn't it seem plausible that in the long run if a firm sees demand for a product is very high relative to supply this would cause the price to move up? I am no expert nor have I looked at empirical data but this seems reasonable. I wont say that the price will clear the market necessarily, but it seems intuitive that higher than anticipated demand for a product could lead to higher prices if inventories are not sufficient.

I mean if all of a sudden somebody came out with a computer that was 10 times faster than any other, they would likely have the price relatively high as long as they are the sole suppliers. As more people come into the market with similar products wouldn't they attempt to undercut this price?

(1) Price rises are not a necessary outcome even in the long run: a competent firm can manage its stock to deal with demand increases.

(2) yes in some competitive markets where goods prices falls as productivity or average costs fall prices may fall. But if it is a mark-up industry will still be set on average costs plus mark-up. The price will probably stabilise at some level.